Managing Regulation in a New Era

The 2008 financial crisis may come to be seen as the demarcation between two regulatory eras. For the past generation, free markets have enjoyed a remarkable intellectual and political ascendancy, championed by academics and governments alike as the best way to promote continuing growth and stability. Now the world suddenly appears to think that some problems are too big and threatening to be solved by free-wheeling businesses. Politicians and commentators of every stripe are calling for greater regulation.

Like most big shifts in the intellectual and political climate, this one appears at first glance to have burst forth overnight. In fact, it's been bubbling beneath the surface far longer. There has been a gradual awareness that self-regulation and corporate social responsibility go only so far in solving big problems. On the day in September 2008 when Lehman Brothers collapsed and the financial crisis became a financial calamity, you may have missed a less prominent news item. Ian Cheshire, CEO of the UK retailer Kingfisher, told the BBC that "there are certain things that are too big, too long-term … to deal with incrementally. We need a government framework." Cheshire, a member of the UK Corporate Leaders Group on Climate Change, was speaking in support of a European effort to reduce greenhouse gas emissions.

A comment by Peter Brabeck-Letmathe, Nestlé's chairman, also failed to attract much attention: "Even though we have perhaps more impact than any other food company, we can only be a small part of the solution [to food and water problems]. The fact is that all our efforts, and those of other companies and consumers, will be in vain if governments throughout the world continue with their short-sighted policies instead of working towards solutions." He too was calling for more state intervention, not unfettered free markets.

Today a pattern is emerging. Tight credit; looming energy, food, and water shortages; and greenhouse gas emissions are high on the minds of business leaders as well as politicians. Consumers too are increasingly worried—and aware that an interconnected global economy means interconnected global problems. They hear about ice caps melting and banks collapsing in distant countries and know that all this matters to their lives, their jobs, their homes, their families. What's more, they expect companies to help alleviate these problems.1 Such developments underscore the expansion of the "social contract" between business and society. The contract includes not only laws and regulations but also a growing obligation for companies to fulfill certain social responsibilities.

From antagonism to cooperation

Against this background of changing perceptions and priorities, regulation is set to assume fresh importance. As always, regulators should find the right ways to mitigate broader market failures—for example, to protect consumers and control environmental pollution—while also seeking to facilitate fair and intense competition among companies, for that will encourage larger increases in productivity, a faster-growing economy, and greater wealth for society to share.2

How should companies prepare? In the previous era, the answer would have been to hire more lawyers and lobbyists and send them off to do battle with regulators. Robert Reich, President Bill Clinton's first secretary of labor, describes in his 2007 book, Supercapitalism, the way intense competition has driven US companies in particular to dramatically increase their efforts to contest every regulatory decision affecting their profitability. Regulation has developed from a legal and political system that is structurally adversarial, so it is no surprise that adversarial attitudes and skills have set the tone in regulatory affairs. But an arms race of investment in legal and lobbying capacity makes less and less sense if governments, policy makers, and companies are to find optimal solutions to huge economic and sociopolitical challenges.

Our research shows that companies are beginning to recognize this truth. In a September 2008 McKinsey Quarterly survey of 1,500 executives,3 the respondents saw regulators as the primary source of the political and social pressures facing companies around the world. But many of these executives were unsure how to respond. They saw lobbying as an overused tool. When we asked them which issues would gain companies little praise for getting things right and a lot of criticism for getting things wrong, "political engagement and influence" came second only to the top team's remuneration.

In practice, companies have three options when they seek to engage a regulator (exhibit). They can maintain arm's-length, often adversarial relationships—limiting communications, so far as possible, to answering requests and deploying legal instruments such as appeals and challenges. At the other extreme, they can seek to build collaborative partnerships with the regulator. Neither model is typically optimal from a company's point of view. The arm's-length approach makes it hard to achieve trade-offs with the regulator and therefore generates antagonism. The collaborative-partnership model is bound to fail, since the regulator is fundamentally a policeman, not a partner. A better approach—and not only in a time of economic crisis—is an open dialogue aiming for constructive engagement with the regulator. Disagreement between the two parties is inevitable. Still, companies have a lot to gain, both for strategic and tactical reasons, from building trust and fostering long-term cooperation not only on small industry issues but also on large ones that may have sociopolitical dimensions.

One argument for the cooperative approach is that regulation is a game played over and over. In many cases, a company persuades a regulator that now is not the time to allow more competition, require reduced emissions, impose higher service obligations, or whatever—only to do much better than the regulator expected in the ensuing regulatory period. Regulators usually react to attempts to fool them by imposing a much harsher settlement in the next round. Trust can fall so far that regulators and companies must communicate through third parties.

This is not the first time we have shared such insights from our work helping companies with their regulatory strategies.4 What's new is this: global economic and sociopolitical challenges have become more acute, and the contract between business and society is expanding, which makes it more important than ever for executives in a wide range of sectors to think hard about their approach to regulatory issues. Companies and regulators don't always have to be adversaries—where there is trust, regulation can become a mechanism for industry-wide, even global, cooperation on issues ranging from financial prudence to scientific innovation and climate change. The negotiation of formal competitive rules in heavily regulated industries is not the whole of regulation.

Increasingly, we see that regulators and companies need to engage each other in an atmosphere characterized by fact-based analysis and trust: regulators can do so by understanding more fully the economics and long-term dynamics of the industries they oversee, and companies by looking for inherently sustainable solutions. Adversarial regulatory contests will no doubt continue, but executives are coming to realize that they must be flexible and ready to make trade-offs.

Network-based industries, such as telecommunications, power, and railroads, are a case in point. New infrastructure investments with very long payback periods (say, fiber networks for telecom services) won't be made unless operators are convinced they will yield satisfactory returns over a reasonable period of time. Regulators face a challenge in balancing the need for these investments with the imperative to reduce end-user prices by encouraging competition and opening up the infrastructure to all players. Rather than bargain hard in order to deny or delay access to competitors across a whole network, some incumbents make a nuanced and well-informed case that takes the interests of governments and consumers into account. This approach might, for example, involve accepting the principle of open access—where competitors are already present—while keeping access temporarily closed in less developed areas, so that investment will flow into them. Although such a compromise won't maximize an incumbent's short-term profits, it might include reasonably favorable terms that wouldn't be subject to constant change.

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